What Does and Doesn't Matter in M&A Strategies
What is the optimal size for a bank? Is there a natural point at which cost and revenue
efficiencies and economies of scale become dominated by diseconomies of scale and scope?
In our recent review of the 150
U.S. banks with more than $4 billion of assets, we found no necessary connection between performance and size or growth rate.
Banks should consider a disciplined approach to mergers and acquisitions and be aware of three myths:
Bigger is better. We found no significant correlation, positive or negative, between size and performance indicators (ROA, ROE, and efficiency ratio). The average
Myth 1: Bigger is Better
compound annual growth of the banks we studied was 15% from 1999 to 2003. The average ROA was 1.3%, the average ROE was 15.4%, and the average efficiency ratio was 56%.
Industry and academic research has argued that economies of scale and scope are most relevant in small- bank mergers. Through the mid-1990s it was generally accepted that efficiencies were exhausted somewhere in the asset range of $2 billion to $10 billion. A 1994 Fed study cited such acceptance.
But using data from the 1990s, a 1997 Fed study found that banks achieved scale benefits at up to $25 billion of assets. It attributed that change to larger banks' enhanced leverage ability; lower open-market interest rates; the removal of regulatory restrictions on bank branching and holding company expansion; and improvements in technology(automated teller machine networks and credit scoring) and applied finance (derivative contract and off- balance-sheet activities).
Smaller banks' increased access to more sophisticated technology potentially offsets those factors. More products and services have become available to players of all sizes; proprietary customer relationship management tools and data warehouse products and services are no longer the domain of large companies only.
Our examination of the top 150 banks did not reveal any significant difference in financial performance between banks with assets of more or less than $25 billion. On the contrary, we found high-growth, high-performance organizations at both ends of the scale.
Myth 2: Smaller is Better
The $190 billion-asset U.S. Bancorp tops the size, growth, and performance charts with 20% annual growth from 1992 to 2004, a 22% ROE, a 2.1% ROA, and an efficiency ratio of 42%. Its focus on customer service has proved itself over more than a decade of spectacular performance.
Toward the opposite end of the size chart, the $5 billion-asset Pacific Capital Bancorp outperformed on all measures: a 28% ROE, a 2.1% ROA, and an efficiency ratio of
47%.
Smaller is better. Observers have questioned the shareholder value of the largest mergers and acquisitions. Bank of America Corp.'s stock price plunged almost 10% in the month following its October 2003 announcement that it was buying FleetBoston Financial Corp.
But with a fourth-quarter return on equity of 16%, a 1.4% return on assets, and an efficiency ratio of 51%, Bank of America is demonstrating that with effective customer integration, bigger can be good.
Myth 3:
Growth and effectiveness are conflicting objectives
The consensus has always been that the average cost curve in banking is a relatively flat U, and that the largest banks are actually at a slight cost disadvantage compared with smaller ones. But the research substantiating that view is limited, and we found no indication that big banks are at such a disadvantage.
One reason the U-shape may no longer be operative at the top end is that big players can flex their buying power. By using reverse auctions, online bidding, and automated and coordinated procurement, they can cut waste dramatically. They also have the benefit of national branding, merchandising, and marketing and promotion.
What Does and Doesn't Matter in M&A Strategies
By: Ricky Mcelroy
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